No Light Yet for Optical Stocks
By Ari Bensinger
Tight capital spending in telecom, along with excess network capacity and product inventories, has forced many investors to throw in the towel on optical-networking stocks. Shares of telecom-networking bellwethers like Nortel (NT ) and Lucent (LU ) have plummeted to the low single digits.
Overall, at Standard & Poor's we believe optical networking -- the fastest way to transport high volumes of data -- will become one of the most important segments of the communications-equipment market. However, we do not expect any significant industry growth until 2004 since carriers will be able to use widespread excess capacity to handle added traffic. S&P projects telecom carriers' capital spending on communications equipment will decline nearly 40% this year.
With the absence of any near-term growth, we believe it's too early to go bottom fishing and would remain underweight (hold less than the sector's weighting in the S&P 500-stock index) on telecom-equipment stocks. Another bad sign is that many stocks in the sector remain overvalued compared to the broad market, even after the group's steep decline.
Two former highfliers that have our lowest STARS recommendation of sell are optical-component maker JDS Uniphase (JDSU ) and next-generation optical-systems maker Ciena (CIEN ). JDS Uniphase is experiencing a dramatic slump in order flow, because of the massive inventory adjustments occurring at its customers -- original equipment makers like Nortel and Lucent. Moreover, system makers are aggressively passing on lower prices to component makers.
JDSU's sales in fiscal 2002, which ends in June, declined an estimated 60%, and we expect it to fall about 10% in fiscal 2003, reflecting a weak telecom spending market. Visibility remains extremely poor, with customers delaying or canceling orders. Given the difficult industry backdrop, we believe JDSU will have a hard time reaching its quarterly sales-break-even target of $300 million any time soon. And even when telecom spending eventually recovers, its titanic base of 1.36 billion shares outstanding will make it extremely difficult to increase earnings per share.
With the lower sales volume, the outfit's gross margins will likely deteriorate to around 30%, well below historic levels of 50%. To improve profitability, JDSU is aggressively restructuring its business to reduce annual operating expenses by over $1 billion. Overall, we forecast an operating loss per share of 3 cents (excluding special charges) for fiscal year 2003, compared to our loss per share estimate of 10 cents for fiscal 2002.
PALTRY BOOK VALUE.
Since we expect operating losses over the next two years, a price-to-earnings valuation is not possible. Using sales as a barometer, the stock -- currently trading at about $4.50 -- has an enterprise value of four times our fiscal 2002 sales estimate, almost double the peer average. Our sales estimates could be reduced further if the industry downturn extends beyond 2003. And excluding intangible assets, JDS Uniphase's book value is a meager $1.77, leaving plenty of room for downside in the shares.
Meanwhile, Ciena made news in February when it announced the acquisition of metropolitan optical-equipment vendor ONI Systems (ONIS ). The $700 million transaction (based on current share prices) values ONI Systems at seven times our 2002 sales estimate, relatively expensive compared to other market-leading next-generation optical players that trade near five times sales.
ONI Systems will greatly enhance Ciena's metro-transport product portfolio (a system that helps transfer data through optical technologies in metropolitan areas) and will add about $700,000 in cash to its balance sheet. However, in the current difficult economic environment, we do not expect telecom carriers to upgrade their networks with next-generation equipment from ONI and its peers in the short term. The addition of about 670 ONI Systems employees will further bloat Ciena's cost structure at a time when savings are needed.
Operationally, we expect Ciena's sales to tumble 70% in fiscal 2002, which ends October. That's because traditional long-haul optical-transport products, which account for the majority of Ciena's revenue, are suffering from significant weakness. Furthermore, new products such as metro-transport systems and optical switches are growing less rapidly than expected.
Gross margins will likely deteriorate to the low teens, hurt by lower manufacturing volumes and intense pricing pressures in the long-haul optical market. For the longer term, however, Ciena's profitability should benefit from an increasing proportion of higher-margin optical-switching products. Operating expenses should remain relatively flat. Overall, we see a fiscal 2002 loss of 67 cents a share, in stark contrast to fiscal year 2001's 60-cent operating profit.
Given its large expense infrastructure, we expect Ciena to post operating losses until the end of 2004. The stock -- recently trading at about $7 -- has an enterprise value of over four times our 2002 sales estimate, well above peer averages. With operating profitability far away, high valuation relative to peers, and a weak industry climate, we would sell Ciena shares.
Analyst Bensinger follows telecom-equipment stocks for Standard & Poor's